This series, brought to you by Yahoo! Finance, looks at which upgrades and downgrades make sense, and which ones investors should act on. Today, our headlines feature new ratings out of JPMorgan for a pair of fast-growing tech stocks -- MercadoLibre (NASDAQ:MELI) and HomeAway (NASDAQ:AWAY). But before we venture too far into tech land, let's take a quick look at one old-economy stock and find out why another analyst is warning investors that ...
... Hershey is melting
Markets are moving upward this morning, but one stock is sitting out the rally: candy king The Hershey Company (NYSE:HSY). For this fact, you can thank the analysts at Argus Research, who chose today to downgrade Hershey shares to hold.
Argus believes Hershey may be worth a bit more than it's currently selling for (say, $100 within a year). Regardless, the analyst worries that shares of the chocolatier may have limited ability to grow more than that as "promotional pricing" erodes profit margins, but has little effect on improving sales. Suffice it to say, Argus feels that the prospect of only a 3.4% return on the stock, even bolstered by Hershey's 2% dividend yield, is not rich enough to justify buying Hershey.
In fact, though, Argus may not be pessimistic enough about Hershey. Priced at 26.4 times earnings, this stock looks expensive based on consensus projections that Hershey will grow profits at about 10% annually over the next five years. Worse, Hershey didn't even achieve that modest level of growth in its most recent quarter, growing earnings only 4.4% -- and sales just 2.4%.
Long story short, this summer is a great time to visit Hershey Park and put Hershey chocolate bars on s'mores for the kids -- but at today's prices, it's just not a good time to buy Hershey stock.
The eBay of Argentina
Turning now to tech, we see investment banker JPMorgan aiming low -- way low -- at South American online auctioneer MercadoLibre, which was tagged today with an overweight rating and a $104 price target. JP likes MercadoLibre's earnings growth potential (which most analysts agree will approach 25% over the next five years). JP also suggests that worries over devaluation risk on the continent are already priced into the stock -- which the banker now assigns a $104 price target, down $10 from its previous estimate.
Investors are jumping on the news, and MercadoLibre shares are rushing higher in response to it -- up nearly 7% as of this writing. But if you ask me, they're jumping the gun and giving too much credence to this ill-thought-out upgrade.
MercadoLibre may have growth potential in spades in the undeveloped Latin American market. And you might even think the stock's valuation at 30 times earnings isn't too high a price to pay for this potential. But the problem with MercadoLibre is that its earnings are of such low quality.
According to S&P Capital IQ figures, MercadoLibre reported earning $130 million in GAAP earnings over the past 12 months. The company's cash flow statements, however, show that MercadoLibre actually only generated $22 million in real free cash flow during this period -- about $0.17 on the dollar, relative to reported earnings. Valued on free cash flow, rather than "earnings," therefore, the stock sells for a sky-high multiple of 175 times FCF. This seems quite a lot to be asked to pay, even if the company is able to grow at 25%, as projected.
With a valuation ranging from slightly to vastly overvalued (depending on whether you value the stock on earnings of free cash flow), there's little reason to buy this stock today -- and certainly not just on JPMorgan's say-so.
HomeAway stock: Go ahead and leave home without it
JPMorgan strikes closer to the mark on its next big tech rating of the day: HomeAway.
At first glance (and second, also), HomeAway seems a pricey stock today, despite having lagged the S&P 500's performance over the past year. Valued on GAAP profits, the stock sells for a startlingly high P/E of 159. Valued on free cash flow (which is admittedly robust), HomeAway looks cheaper, but still expensive at a valuation of 32-times FCF. Growth estimates quoted on S&P Capital IQ, meanwhile, have most analysts positing 25% profits growth at the company over the next five years.
On its face, a valuation of 32x FCF seems expensive for a 25% grower. But according to JPMorgan, the situation could be even worse than it appears. JP warns investors to expect "greater marketing spend and downward guidance revision during the upcoming Q2 earnings conference call." This raises the possibility that the company could both miss on earnings (from reporting higher costs than most investors are counting on) and disappoint on guidance going forward.
For value investors, too, this would be bad news -- depressed earnings would raise the P/E and P/FCF ratios on the stock, while lowered guidance could slow down the projected growth rate. JP's take on all of this is that "visibility will be limited in the near-term and return on marketing spend could take some time." From an investor's perspective, though, the conclusion is even clearer:
As HomeAway shares look increasingly expensive, the stock price must fall.
Rich Smith has no position in any stocks mentioned, and he does not always agree with his fellow Fools. Case(s) in point: The Motley Fool recommends both HomeAway and MercadoLibre, and even owns shares of MercadoLibre.
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